The Mideast countries hardest hit by oil prices

The energy-price rout is increasing the pressure on many Middle Eastern economies to implement structural reforms.

Deeper fiscal and economic adjustments are required even under our base case of a gradual rise in energy prices in the second half of this year. An escalation of the conflict between Saudi Arabia and Iran or an exacerbation of social unrest in the region, another plunge in energy prices, or a spike in U.S. interest rates will all add to pressure on local exchange rate systems, interest rates, and credit spreads.

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A worker stands at a pipeline, watching a flare stack at the Saudi Aramco oil field complex facilities at Shaybah in the Rub' al Khali ('empty quarter') desert in Shaybah, Saudi Arabia.

The fall in oil prices caused a number of sovereign credit-rating downgrades over the past year in the Gulf region, including in the case of Saudi Arabia. As no significant recovery is expected in the near term, we think low oil prices will continue to weigh on the credit quality of sovereigns in the region. GDP growth will also likely slow this year on the back of fiscal consolidation efforts, and as confidence and liquidity effects dampen economic activity.

As their exchange rates are pegged to the U.S. dollar, Gulf countries cannot devalue their currencies and thus boost the local-currency value of their oil revenues. Instead, they have attempted to cut spending or increase revenues through subsidy or tax reforms and capital expenditure cuts. Fiscal measures have been positive from a credit perspective but will not fully compensate for oil revenues, in our view. Gulf countries' average budget deficit reached double-digit levels in 2015. They may moderate and reach high single-digit territory this year, but they still compared unfavorably with the double-digit surpluses recorded in the 2004-14 period.

Of the individual players in the region, Qatar, Abu Dhabi, and Kuwait are more resilient to oil shocks than Saudi Arabia, Oman, and Bahrain. Their high per capita hydrocarbon production has ensured they can break even fiscally even if oil prices are low and has enabled them to accumulate ample foreign exchange assets. Their policy responses so far, such as Qatar's water and electricity price hikes and the United Arab Emirates' fuel price reforms, are also positive, in our view, as they prevent rapid erosion of fiscal buffers.

By contrast, Bahrain, Oman, and Saudi Arabia are more vulnerable. They need higher oil prices to break even fiscally and they have lower fiscal buffers. This exposes them to further potential ratings downgrades in 2016. Oman and Saudi Arabia are targeting a budget deficit of 13 percent in 2016, despite fiscal consolidation measures – Oman has increased corporate tax rates and cut subsidies by 64 percent and increasing corporate tax rates, while Saudi Arabia has cut government expenditure in absolute terms for the first time since 2002.

Despite mounting pressure on currency pegs, our base case is that Gulf Cooperation Council countries will maintain their current exchange rate regimes over the next 12 months. However, some are better positioned to extend this beyond two to three years. In Saudi Arabia, fiscal buffers might be exhausted within five to six years without any adjustments. Bahrain and Oman both require oil prices of $100 a barrel to break even fiscally. Estimations suggest that fiscal buffers will be exhausted in less than five years, assuming an average oil price of $50 a barrel. With low energy prices, policy makers in the region will have to address major economic challenges to sustain the pegs.

Geopolitical tensions in the region are also a factor. Although we view the confrontation between Iran and Saudi Arabia as a battle for regional supremacy rather than a religious dispute, the conflicts between Shias and Sunnis in Yemen, Syria, and Iraq are likely to continue, and an escalation in any of these countries or a flare-up elsewhere in the Middle East remains a possibility. Nevertheless, we think neither Iran nor Saudi Arabia or their international partners wish for an escalation at this stage.

For bond investors, there are two main takeaways. The first is supply. All Gulf Cooperation Council sovereign borrowers have the potential to issue hard-currency bonds this year, given large financing needs and tightening domestic liquidity. This could include the first Saudi Arabian euro-bond issuance in history. The second takeaway is the gap or spread between yields on benchmark government bonds and bonds from Gulf issuers. Given low energy prices and significant economic and political challenges, these are likely to remain under upward pressure. As no significant recovery is expected in the near term, we think low oil prices will continue to weigh on the credit quality of sovereign entities in the region.